Smart contracts: revolutionary or out of reach?

@LawAhead

The digital flood leaves nothing untouched, and the legal field is no exception. One technological advance that has particularly interesting implications is ‘smart contracts,’ blockchain-based software programs that are making humans’ jobs easier. Experts are putting the technology under the microscope to weigh its pros and cons.

With the advances in technology, specifically the implementation of smart contracts—that have been around since the last century[1]— and after the enormous success of bitcoin, experts have realized the extent of the tool’s powerful applications.

Smart contracts are essentially software programs that run on blockchain platforms[2]. They’re considered contracts because they replicate normal contracts, and intelligent because they’re self-executing. Rather than being written on paper, smart contracts are coded like a computer program. This allows them to benefit from some of the advantages of the digital world, such as speed, security, autonomy, and efficiency. In fact, advocates of smart contracts argue that they’re safer and more cost-efficient than traditional contracts. However, their scope and usability remains to be seen, as they have some flaws. Here, we’ll explore the pros and cons of smart contracts today.

 

Certainty through self-execution

As we’ve already mentioned, smart contracts are considered smart because they’re self-executing. And depending on their type of execution, they’re divided into two categories.

The first type are those whose precise execution is known at the time of creation, for example, Within twenty days, ‘A’ must pay ‘B’ 20 euros. The advantage of this type of smart contract is that it doesn’t require further input to be executed.

The second type are those smart contracts whose execution is linked to a certain but unknown event or condition which cannot be coded at the moment of creation. An example of this type of contracts is: ‘A’ will pay ‘B’ 20 euros if ‘B’ gets a distinction in her dissertation. In these contracts, a third agent is responsible for communicating that the missing condition has been fulfilled (i.e. ‘B’ gets a distinction). These agents are called oracles and are usually appointed when the contract is created[3].

The main advantage of self-execution is that it provides certainty to contractors by guaranteeing that the contract will be executed on the terms they indicate. Therefore, in the event of a contract dispute, contractors don’t have to worry about unpredictable decisions by judges, and the resolution of the dispute is sped up.

It’s worth pointing out that smart contracts only offer a higher level of certainty and efficiency if no oracle is involved. Although oracles don’t interpret the terms of smart contracts, they do decide if the condition that must be met in order to execute the contract has been fulfilled. Consequently, if this condition is not objective in nature, the oracle will have to decide unilaterally whether it has been fulfilled, so the problem of intermediaries reappears.

This diminishes the objectivity of smart contracts—and with it, their attractiveness. If smart contracts aren’t certain, they provide no real advantage over regular contracts. Smart contracts without oracles may always be certain, but not every situation can be executed without oracles. Indeed, the main argument for the incorporation of oracles is to make smart contracts more flexible and expand their scope.

It’s worth pointing out that smart contracts only offer a higher level of certainty and efficiency if no oracle is involved. Although oracles don’t interpret the terms of smart contracts, they do decide if the condition that must be met in order to execute the contract has been fulfilled.

Security and trust through immutability

When implemented, smart contracts are immutable and very difficult to hack—in fact, they can only be hacked if they have a bug. They’re also made safer by their back-up copies: identical replicas that solve the problem of alteration or loss of the original contract. This security measure reinforces trust in the system by ensuring that the contract will be executed under any circumstance[4]. Unfortunately, immutability makes smart contracts rigid, and this rigidity is not always a good ally in contractual relationships.

Proponents of smart contracts forget that contract law can be flexible. In fact, modifications to contracts during their term are common in contractual relationships. This allows contractors to update their contracts to future situations without having to create and sign a brand new one. Common situations in commercial relationships, such as condonations or payment flexibility, cannot be embodied in a smart contract. This circumstance greatly reduces the incentive to use smart contracts for dynamic and long-lasting relationships, and therefore undermines the credibility of the idea that smart contracts can fully replace current contracts.

Finally, the digitalization of contracts eliminates the human side of contractual relationships, which aren’t just governed by hard-and-fast laws, but also non-legal aspects such as kindness, emotions, customs, or affinity. Sometimes, these non-legal issues even prevail over legal issues. For example, a landlord may decide not to automatically evict his tenant from his property because he knows that the tenant has recently lost his job, or because the delay in the payment is not significant. In these situations, the landlord has the right to evict the tenant from his property, but out of kindness or common sense, he decides not to “execute” the contract. With smart contracts, these types of situations would disappear, and verdicts would be automatically fulfilled.

Finally, the digitalization of contracts eliminates the human side of contractual relationships, which aren’t just governed by hard-and-fast laws, but also non-legal aspects such as kindness, emotions, customs, or affinity. Sometimes, these non-legal issues even prevail over legal issues.

 

No intermediaries, less costs

Smart contracts are considered cheaper than regular contracts because there are no intermediaries. But this conclusion is flawed: it would be more accurate to say that smart contracts are cheaper in the long term, as long as the regular contracts they replace are not litigious. In the short term, creating a smart contract is actually more expensive than drafting a traditional contract, because at least two experts are involved in the creation of smart contract: a lawyer for legal matters and an engineer for coding. Some experts have tried to solve this problem by announcing the possibility of having standard terms to which parties can adhere[5]. However, this solution would reduce the scope of smart contracts as long as solely previously coded situations could be incorporated in them.

Another reason smart contracts are not necessarily more affordable than regular contracts is because while a regular contract can be modified during its term, a smart contract is immutable. Therefore, if contractors decide to alter any of the terms of the smart contract, they will have to code a new contract from scratch.

Finally, if a traditional contract is never challenged and is not debated in court, it will always be cheaper than its respective smart contract. It is only when there are problems in the execution that smart contracts offer advantages over normal contracts.

 

 Not quite there yet

No one can deny that smart contracts are popular and useful, but we’re still very far from seeing them replace all regular contracts. For now, smart contracts will primarily be used in those sectors in which security and certainty are a must: for example, in the financing or insurance sectors, where automation does not represent a major evil. Nevertheless, in everyday situations, smart contracts aren’t yet a plausible alternative due to their rigidity. They’re also quite expensive compared to the limited benefits they bring.

Apart from the costs, smart contracts would need to be massively adopted in order to present a real threat to traditional contracts. This is the case with any disruptive technology that tries to challenge the status quo. One example of this is bitcoin, which may be seen as an attractive financial speculative instrument, but in order for it to become an alternative to real money, it would need to be massively adopted. The same goes for smart contracts: they cannot aspire to be a real alternative if there isn’t a huge network that supports them. Unfortunately, this isn’t likely to happen in the near future, because for smart contracts to be implemented across the board, governments and public institutions would also have to support them.

Eduardo Novella González del Castillo is an associate at Uría Menéndez. He conducted his studies at the University of Zaragoza and at the London School of Economics and Political Science (LSE) where he studied an LLM in Competition, Innovation and Trade Law. Currently, Eduardo exercises his practice at Uría Menedez where he provides advice in relation to EU and Spanish competition law and EU law. Additionally, Eduardo has been actively working in the Digital Law Department of Uría Menéndez dealing with issues relating to software, data protection and e-commerce.

Note: The views expressed by the author of this paper are completely personal and do not represent the position of any affiliated institution.

[1] Nick Szabo «The idea of smart contracts.«
[2] Currently, the most important platform to implement a smart contract is Ethereum. Nevertheless, smart contracts can be created through other platforms.
[3] Massimo Bartoletti and Livio Pompianu. «An Empirical Analysis of Smart Contracts: Platforms, Applications, and Design Patterns.» (International Conference on Financial Cryptography and Data Security. Springer, Cham, 2017).
[4] Carlos Tur Faúndez “Smart Contracts. Análisis jurídico” (Reus, 2018).
[5] Stuart D. Levi  and Alex B. Lipton “An Introduction to Smart Contracts and Their Potential and Inherent Limitations” (Harvard Law School Forum on Corporate Governance and Financial Regulation) accessible here